3rd Quarter 2020

This year, the U.S. federal government’s debt relative to gross domestic product (GDP) is expected to be at the highest level since World War II. This rise is due to the major fiscal response by the Administration and Congress to the COVID pandemic coupled with deficit spending trends in recent years. The Federal Reserve Bank of St. Louis projects this year’s level will be well over 100%. Only a handful of economies such as Greece, Italy and Japan have debt loads that exceed their economies. The last year U.S. debt exceeded GDP was in 1946, when it was at 106% after four years of war. 

The novel coronavirus that swept the globe in early 2020 also compelled the Federal Reserve to intervene in an unprecedented fashion. Its aggressive and swift action calmed financial markets, which led to a rebound in many asset prices. The Fed lowered its main interest rate back to near zero in March. It has ramped up its bond buying programs – known as quantitative easing – to pull down long-term rates. Between mid-March and mid-June, the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.1 trillion. The Fed introduced multiple temporary lending and funding facilities to help institutions with borrowing needs. It has indicated its easy money policy, with low interest rates, will continue for the indefinite future.

1st Quarter 2019

After two seemingly polar-opposite quarters, one thing not in short supply is the number and diversity of market commentaries and outlooks going into 2019. Through February, the U.S. stock market had its best first two months of the year since 1991 amid mixed economic news following the worst December since the dramatic days of 1931.  The increase in volatility comes after a long period of ever-increasing valuations and steadily advancing markets. Many investors have become accustomed to the robust valuations and low volatility of an almost decade-long bull market. The sudden sharp volatility of a potential new “normal” calls for perspective, particularly for investors who feel nervous and compelled to act during such stress points.

The duration of this bull market has the potential to cause investors to make the wrong decisions, vis-a-vis their portfolios, when volatility reappears after a long hiatus. As we approach the 10^th anniversary of the second longest bull market in modern times, the phenomenon known as “recency bias” can be a dangerous trait for investors. “Recency bias” is a cognitive condition that lulls us into believing what has happened in the recent past will continue for the foreseeable future. Investors continuously fall victim to this bias during both positive and negative market cycles.

Our brains are conditioned in such a way that recent memories are more easily recalled. Thus, it is completely reasonable to think the market will perform well when we’re in a bull market, even though most investors are cognizant of the cyclical nature of the stock market. Alternatively, when the market turns negative, we may be inclined to think that these conditions will persist and reactively liquidate stock positions. Obviously, selling low is not a good long-term investing strategy. Markets recover and invariably those who have sold are likely to be still sitting on the sidelines.

There is a strongly held perception that Wall Street’s analysts tend to call a stock a “strong buy” when its price and earnings are high and to label it a “sell” after its price and earnings have fallen. Many investors also tend to follow the momentum of the market, wanting to invest when the market is rising and sell when the market is falling. Such investors and even some sophisticated stock analysts confuse the high earnings during favorable economic times with the average earnings power of the company. Investments purchased at peak earnings or at high multiples often do not offer an adequate margin of safety or long-term rate of return.

Value investing is conceptually easy to grasp but a difficult discipline to practice as it runs contrary to a herd mentality. 

Margin of safety is a fundamental principle of value investing, which states that an investor will purchase a stock if it is priced below its intrinsic value. Intrinsic value is the economic value of a company based on its long-term earnings power. The difference between the purchase price and the intrinsic value is the margin of safety. The greater the difference, the larger the margin of safety that provides an extra cushion in the event of future pressure on earnings from a myriad of factors (economic, market or company specific). Prices fluctuate more than intrinsic value, meaning opportunities exist to take advantage of irrational pricing and market psychology. 

The purpose of margin of safety is not just to preserve the initial capital investment, but to improve upon it. When a stock is purchased below its fair or intrinsic value, the expectation is that in some future time period the stock price will converge with its fair value in a rational market. If the growth expectations end up being correct, an investor who has bought at the discounted price will ultimately earn a superior rate of return.

Our First Quarter Letter noted that the current bull market celebrated its eighth anniversary on March 9, 2017. Value investing and margin of safety concepts are not so attractive in rising markets. The essence of value investing is finding a veritable bargain, which can be difficult in an aged bull market. As we’ve mentioned before, value investing is conceptually easy to grasp but difficult to practice as it runs contrary to a herd mentality. It entails researching investment options in depth, usually to discover the stock is fairly priced even though it shows some value attributes. It requires patience and a willingness not to participate in market momentum or a particular sector fad. It also requires fortitude to invest “in the foulest of weather.” Purchasing stocks in a declining market without knowing the bottom can be challenging. Stocks tend to trade at their greatest margin of safety during negative economic periods when investors are overly pessimistic.